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09/28/2008

The Financial Crisis II-Becker

In considering what needs to be done to improve the functioning of the financial system, it is necessary to distinguish steps to avoid a major depression in the near term from long run reforms of the financial system. The Paulson Plan naturally concentrates on the very real short run emergency. I first discuss this plan and other suggestions, and then briefly consider long-term reforms.
The Treasury's announced insurance of all money market funds carries considerable moral hazard risks, but it has not aroused much controversy. The Paulson Plan goes much further and involves purchases from banks of up to $750 billion of assets that have uncertain worth. I say uncertain worth since there is essentially no market for many of these assets, and hence no market pricing of them. The government hopes to create this market through using reverse auctions. In these auctions, banks would offer their assets at particular prices, and the government would decide whether to buy them. This part of the Plan has been heavily criticized because it gives great discretion to the Treasury Secretary since the total value of the assets that would be purchased at this point is not known. In addition, many are repelled by the intention to bail out companies and their executives who made decisions that got the companies into trouble. There is also much concern about the moral hazard consequences for the future behavior of banks if they are led to expect to get rescued by the government when their investments turn sour.
While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse. However, the proposed Plan does indicate, as I suggested in an earlier post (April 28, 2008), that the $29 billion bailout of the bondholders of Bear Stearns in March was a mistake. It probably did have a moral hazard effect by encouraging Lehman brothers and other investment banks to delay in raising more capital because they too expected to be helped if times got much worst.
The agreement apparently just reached between Congress and the White House does allow the government to purchase distressed assets up to about $700 billion- I would have preferred a considerably smaller initial limit. It does have a provision for Congressional oversight of the Treasury's use of the funds, whatever that is worth, and has several other features as well. For example, it includes pay limits for executives whose firms seek government help. That is too much micromanagement of the operations of these banks, even though no one can think much of executives who led their banks into such a mess.
I am also not enamored of the apparent provision that gives the government an equity stake in some banks that they help if these banks should prosper. It is unwise to allow governments in general to have equity interests in private companies, particularly if this equity gives them voting rights on company policies. Perhaps inevitably, this did occur in the AIG bailout. Many examples in recent history, such as the current Alitalia fiasco, show that political interests outweigh economic ones when governments have partial ownership of alleged private companies.
The agreement appears to require the government to use their new ownership of distressed mortgage-backed securities to reduce home foreclosures. Homeowners as well as bankers should have known that the insanely good times in the housing and mortgage markets could not last forever. However, consumers are less well informed about financial matters and housing pricing than are the supposed expert executives at banks. Helping homeowners also uses taxpayers money, but in a way that would generally aid people with modest to moderate incomes. Indirectly, moreover, it would also help banks by increasing the value of the mortgage-backed securities they hold.
One suggested supplement to the Paulson Plan is to require investment banks and other financial institutions to raise additional capital now, so that they have resources to start widespread lending again. Such a requirement would be unwise since banks that can raise capital readily are already doing so, as illustrated by Warren Buffet's investment in Goldman Sachs, and Mitsubishi's purchase of a stake in Morgan Stanley. Were such a requirement imposed, weaker banks might cut their lending even further in the attempt to increase their liquid capital. Milton Friedman and Anna Schwartz argue convincingly in their Monetary History of the United States that the Fed's raising of reserve requirements for commercial banks during the mid-1930s contributed to a prolonging of the Great Depression. For it induced these banks to further contract their lending in order to gain the liquid assets that were removed by higher reserve requirements.
The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have little understanding of how the whole incredibly complex financial system operates when exposed to various types of stress. In light of such ignorance of the financial system's mode of operation, it is difficult to propose long-term reforms. Still, a few seem reasonably likely to reduce the probability of future financial crises. The capital requirements of banks relative to assets might be increased, so that the highly leveraged ratios of assets to capital in financial institutions during the past several years would become less common. Possibly a minimum ratio of capital to assets should be imposed by the Fed on investment banks and money funds. As much as possible, the measure of capital should be market, not book, value, such as the market value of publicly traded shares of banks. My discussion last week indicated that book value measures badly missed the plight of Japanese banks during their decade-long banking crisis of the 1990s.
The government should as quickly as possible sell Freddie Mac and Fannie Mae to fully private companies that receive no government insurance or other help. These two giants did not cause the housing mess, but in recent years they surely greatly contributed to it, partly through Congressional pressure on them to increase their purchases of sub prime loans. They owned or guaranteed almost half of the $12 trillion in outstanding mortgages with less than $100 million of capital. The housing market already has excessive amounts of government subsidies, such as from the tax exemption of interest on mortgages, and should not have government sponsored enterprises that insure mortgage-backed securities.
Finally, the "too big to fail" approach to banks and other companies should be abandoned as new long-term financial policies are developed. Such an approach is inconsistent with a free market economy. It also has caused dubious company bailouts in the past, such as the large government loan years ago to Chrysler, a company that remained weak and should have been allowed to go into bankruptcy. All the American auto companies are now asking for handouts too since they cannot compete against Japanese, Korean, and German carmakers. They will probably get these subsidies, even though these American companies have been badly managed. A "too many to fail" principle, as in the present financial crisis, may still be necessary on hopefully rare occasions, but failure of badly run big financial and other companies is healthy and indeed necessary for the survival of a robust free enterprise competitive system.

The capital requirements of banks relative to assets might be increased, so that the highly leveraged ratios of assets to capital in financial institutions during the past several years would become less common. Possibly a minimum ratio of capital to assets should be imposed by the Fed on investment banks and money funds. As much as possible, the measure of capital should be market, not book, value, such as the market value of publicly traded shares of banks.

These are very useful things to ponder: what specific regulation do we need to prevent another internally-generated systemic threat?

Regarding the ratio of capital to assets, the old "investment bank" rules are basically a ghost town now that all the investment banks have converted to become commercial banks. Commercial banks have tighter capital requirements and generally more regulation.

But that's probably not enough: even commercial banks (WaMu, Wachovia, more) seem to have been undercapitalized. And as the crisis recedes into history, especially if the bailout is successful at reducing pain for the country, "free marketers" will demand less regulation in the interest of "efficiency."

Mark-to-market is an important principle and I agree it is important. It didn't save the investment banks who, unlike insurance companies, did have to mark to market all of the assets on their books. Also, illiquid off-balance-sheet entities may have been used to avoid the real consequences of mark-to-market -- there's no market for them, so they can be carried at purchase price unless certain material events occur, even if the entity owns some fraction of marketable securities.

Mark to market also increases volatility by making capital appear (as if by magic) during good times, only to disappear exactly when it is most needed. I don't know any real solution to this dilemma; heaven knows book value doesn't work either, since it bakes known-false assumptions into values, so that values can't be trusted.

Questions like this -- "what is appropriate regulation?" -- need to be answered by the best and the brightest. But they (we) are off making themselves rich within the system, leaving the maintenance of regulations to those who don't thoroughly understand the system. Lobbyists gain excessive power not because politicians overall are corrupt, but because politicians don't have sophisticated understanding of their own, so they rely on self-interested others to explain things to them.

One question persists for me though: Given that we all knew this bubble was gonna pop someday, and we were just hoping the damage would be mild, who in academia was doing serious planning for how to mitigate the damage? Clearly Paulson was improvising without a script. We're too smart to do this to ourselves...

There is great moral hazard to the bailout. If our current leaders act to provide what they apparently intend to provide (bill version as of late Sunday evening, Sept. 28, 2008), they will have forever changed America.

We have to have a reasonably free economy. Such freedom presumes that the economy we have is an evolving econonmy. Economic evolution will not take place if the government engages in the bailout proposed.

The government is blinking.

Moreover, the bailout proposed will engender an utter lack of faith in government and ourselves. What some leaders seek to do has nothing but hazard to it, moral hazard. And, like war, it will present a host of unintended and unforeseen consequences.

One clear concern in the current panic is the "too big to fail" mentality. What would be the issues resulting from a long term solution that seeks to prevent future banking and financial concerns from attaining such a position of influence ? If Standard Oil can be forcefully broken up due to fears of excessive economic power, why not the banks that are "too big too fail" ?

I would just like to differentiate between the financial and automotive "bailouts". The loans to the American auto manufacturers are direct loans, with a clear repayment plan. Without these loans it would be nearly impossible for the manufacturers to comply with the misguided CAF√â standards. I do not disagree that the previous Chrysler loan was unnecessary, but it was not without precedent.

In the interest of full disclosure I am currently employed at one of the aforementioned companies (not in an executive capacity). As such, I have done quite a bit of research on the industry. I believe that a lot of the resentment towards the (former) Big Three would be alleviated if more people would take the time to inform themselves as to what's happening.

The blog below captures a few of the key flaws with CAF√â. It doesn't outright say that an increased tax on gasoline would be the best way to achieve the demand shift needed to produce the outcomes CAF√â intends, but I believe that it is the best answer (assuming those outcomes are in fact desirable).

"Helping homeowners also uses taxpayers money, but in a way that would generally aid people with modest to moderate incomes."

I am alarmed at the ease with which this concept is arm-waved away as a non-issue. Should the government pick winners and losers among next-door neighbors? If the overwhelming majority of Americans pay their mortgage on time and within their household budget...then why should we make these people feel like schmucks for doing the right thing? It will be awfully hard having watched your neighbor execute multiple cash-out refinancings to finance a small fortune on cars, vacations, flat-screen TV's and granite countertops- to then watch that same neighbor receive a mortgage principal reduction from the government.

Our very culture of personal responsibility and freedom is at stake when the government intervenes to choose favorites among ordinary citizens.

The process in Washington, D.C. keeps coming untracked because the players keep angling to choose winners & losers instead of meeting the beast head-on. Maybe today's vote - when all other cover fails you vote your District - will put the kibbosh to that. I'll guarantee you a respectable assortment of congressional members & staffers as well as financial agency bureaucrats pay attention to what "Becker" and "Posner" have to say about saving the economy.

As much as possible, the measure of capital should be market, not book, value, such as the market value of publicly traded shares of banks.

Who' doing the measuring? Banks should simply report the book value of their assets at cost, and let investors compare that against the current market price and volume for "comparable" assets. Why should the market not be used to process information about price?

By letting management inside these financial institutions decide how to report asset value, we've created a private form of socialism (in the sense of central planning).

Haha, what would happen if the fed wrote the bush twins a check for a googleplexzillion dollars and they used it to pay off all the debt that's a problem? As long as the government can just make up money to solve the problems why stop at 750 billion?

I enjoyed your valued insights into this financial crisis very much. I think that the argument which basically says that wealthy people are being saved at the cost of the unwealthy is fundamentally untrue for two reasons: The wealthy are paying a hefty price, undoubtedly man top execs will be replaced or reprimanded for poor choices. The Gov's plan, saving the rich is more like an unintended consequence of saving everyone else . Second much more is at stake than wall street, a credit crunch could affect employment, education opportunities, and economic growth in a very substantial way. This should be avoided at all cost. Also many firms which were practicing ethical and high standard lending practices are also being dragged down, which isn't good for anyone. So i think the moral hazard argument is being overplayed, it has some weight but not enough to stop the rescue plan.

Did anyone see the letter in today's WSJ suggesting that the Nobel economics prize be discontinued. The writer wonders how Americans can win that prize most of the time and then cause one of the worst financial slopholes in our history. The other possibility is that the politicians are too dumb to understand what they are being told. I vote for the latter theory.

First, I second Mary Ellen's proposal for million dollar handouts to us all.

Second, why do so many assume that falling real estate prices are a bad thing? Why do we assume that deflation is to be avoided at all costs? It seems that this deflation-phobia is very likely the motivation behind Alan Greenspan's move to force interest rates so low for so long.

I assume that Greenspan and others look at Japan and conclude that their deflation is the cause of their stagnation. The problem with that analysis is that the Bank of Japan, contrary to popular impression, tried monetary expansion.
There is also good evidence that they were not in a liquidity trap. Japan's expansionist monetary policy did not work because it is likely that their real pool of funding was too low or was misdirected by governmental policy.

I would just like to differentiate between the financial and automotive "bailouts". The loans to the American auto manufacturers are direct loans, with a clear repayment plan. Without these loans it would be nearly impossible for the manufacturers to comply with the misguided CAF√â standards. I do not disagree that the previous Chrysler loan was unnecessary, but it was not without precedent.

The question of what needs to be done most urgently has scarcely changed over the past year. As I wrote in a casual circular to friends before last Christmas:

"The overdue collapse of the business of repackaging dubious mortgages, etc. hasn‚Äôt produced the economic recession that it might have. (People biting their nails over a possible collapse of some of our banks are just spoiling their appetite for mince pies. The governments of China and of the major oil producers ‚Äì as well as many vulture funds - would be enchanted at a chance of buying up a few major Western banks. They have plenty of money available.)"

The problen behind the credit crunch is that a lot of this bank capital has still not been raised. As a result, banks in Europe and the USA do not trust one another sufficently to lend to one another at less than penal rates.

The evident fact is that many bank managements have not been willing to pay the market price for this capital. An extreme case is Lehman Brothers mangement refusing capital from the Koreans shortly before seeking Chapter 11. Lehman Brothers' debtors and shareholders now rue that refusal. Whether it was malfeasance in respect of duty to the creditors to have refused this offer (practically whatever its terms) is likely to be a matter for the Courts.

The general point is that many bank and other finacial corporation mangements have declined to accept additional capital on the terms at which the market was willing to offer it, apparently with the objective of protecting their personal positions at the expense of debtors and shareholders. If they are allowed to get away with this without contundent penalty, the moral hazard which their successors will pose to a free market for capital will be intolerable. In the jargon of economics, a necessary part of the solution of this crisis is attention to this very serious collective agent:principal problem.

The Paulson plan, even as amended, addreses another issue; a problem that is usual at the onset of a recession. There is a mass of bad debt to be worked off. This time the mass is unusually large, and the bad debt is in amazingly complex forms. A major plan wil be wanted, in due course, to cover this work-off over the next few years. Further amendment to the Paulson plan may be adequate for that.

However, the urgent issue is the banks reluctance to lend to one another, and that traces back to their failure to raise extra capital in the past year. The acute problem is to see that banks and finacial corporations raise the necessary capital, capital that the market is probably willing to offer on the its terms; while seeing to it that managements who have failed to raise that capital in the market during the past year suffer relative to those who did raise the capital needed.

Th encouraging development today is that the Wells Fargo management have bet their bank (and Wachovia) on their willingness and ability to raise $20 billion capital in the market. That means taking equity funds at the market rate.

The question is will the others take their medicine, or will the authorities have to force it down their throats? In the few days since the Paulson plan appeared, several academics have set out schemes for effectively force-feeding additional capital.

The representatives of the people of the United States of America have changed America in on fell swoop. America will never be the same again. None of us will ever be the same again. We have confirmed this: We are no longer a nation of courage, we are a nation of followers. We are a nation which gives way to fear, mostly fear which has been falsely manufactured. ‚ÄùWe have nothing to fear but fear itself‚Äù FDR said. America has completely disagreed with FDR. ‚ÄùFear itself, is is something to fear.‚Äù

The representatives of the people of the United States of America have changed America in on fell swoop. America will never be the same again. None of us will ever be the same again. We have confirmed this: We are no longer a nation of courage, we are a nation of followers. We are a nation which gives way to fear, mostly fear which has been falsely manufactured. ‚ÄùWe have nothing to fear but fear itself‚Äù FDR said. America has completely disagreed with FDR. ‚ÄùFear itself, is is something to fear.‚Äù